microeconomics for businessUnit 313 min read

Demand Elasticity: Theory, Measurement & Business Applications

Unit 3 of microeconomics for business covers elasticity of demand (price, income, cross), its measurement (point, arc, total expenditure), determinants, and real-world applications in pricing, advertising, and policy—with Nepalese examples like Daraz discounts and NTC tariffs.

Padhai · Based on the official syllabus and past papers
Updated 11 Oct 2026

TAKEAWAYS:

Elasticity measures percentage responsiveness of quantity demanded/supplied to price/income changes, not absolute changes.
Price elasticity of demand (PED) determines whether total revenue rises or falls when prices change—critical for businesses like Daraz or Ncell.
The arc elasticity method is used for larger price ranges (e.g., NTC’s electricity tariff adjustments), while the point method works for small changes (e.g., Pathao’s surge pricing).
Income elasticity explains why demand for smartphones (luxury) grows faster than rice (necessity) as income rises in Nepal.
Cross-price elasticity predicts substitute/complement relationships (e.g., Khalti vs. eSewa, or petrol vs. public transport).
Businesses use elasticity to set pricing strategies (e.g., airlines’ dynamic pricing), advertising budgets, and tax policy responses.

1. What is Elasticity? The Core Idea

Elasticity measures how much one economic variable responds to changes in another. Unlike slopes (which depend on units), elasticity is unit-free and percentage-based, making it comparable across markets.

Why Does It Matter?

Business decisions: Should Daraz raise prices on electronics (elastic) or groceries (inelastic)?
Government policies: Will a 10% tax on cigarettes reduce smoking (highly elastic) or just raise revenue (inelastic)?
Consumer behavior: How do Nepalese react to fuel price hikes (supply-side elasticity)?

Key Types of Elasticity in Demand

Type	Formula	Interpretation
Price Elasticity	$E_{d} = \frac{%Δ Q _{d}}{%Δ P}$	Measures responsiveness of quantity demanded to price changes.
Income Elasticity	$E_{i} = \frac{%Δ Q _{d}}{%Δ I}$	Measures how demand changes with income (normal vs. inferior goods).
Cross Elasticity	$E_{x y} = \frac{%Δ Q _{d} ( x )}{%Δ P ( y )}$	Measures how demand for good x changes when price of good y changes.

2. Price Elasticity of Demand (PED): The Workhorse of Business

PED tells us whether total revenue (TR = P × Q) increases or decreases when price changes.

How to Calculate PED

Two methods:

Point (Mid-Point) Method (for small changes): $E_{d} = \frac{Δ Q / Q _{a v g}}{Δ P / P _{a v g}} = \frac{Δ Q}{Δ P} \times \frac{P _{a v g}}{Q _{a v g}}$ Where $Q_{a v g} = \frac{Q _{1} + Q _{2}}{2}$ , $P_{a v g} = \frac{P _{1} + P _{2}}{2}$ .
Arc (Total) Method (for large changes): $E_{d} = \frac{Q _{2} - Q _{1}}{Q _{1} + Q _{2}} \div \frac{P _{2} - P _{1}}{P _{1} + P _{2}}$

Worked Example: Daraz’s Smartphone Pricing

Suppose Daraz sells a smartphone at Rs. 20,000 (quantity demanded = 100 units). After a discount, price drops to Rs. 15,000 (quantity demanded = 150 units). Calculate PED using the arc method and advise Daraz.

Solution: $E_{d} = \frac{150 - 100}{100 + 150} \div \frac{15 , 000 - 20 , 000}{20 , 000 + 15 , 000} = \frac{50}{250} \div \frac{- 5 , 000}{35 , 000} = 0.2 \div (- 0.1429) = - 1.4$ Interpretation: $∣ E_{d} ∣ = 1.4 > 1$ → Elastic demand. Advice: Daraz should lower prices to increase total revenue (since demand is sensitive to price).

Degrees of Price Elasticity

Elasticity Range	Interpretation	Total Revenue (TR) Effect When Price ↑
$E_{d} > 1$	Elastic	TR falls (consumers switch away).
$E_{d} = 1$	Unit elastic	TR unchanged.
$0 < E_{d} < 1$	Inelastic	TR rises (consumers stick).
$E_{d} = 0$	Perfectly inelastic	TR rises (e.g., life-saving drugs).

Real-World Tie-In:

NTC’s Electricity Tariffs: Household demand for electricity is inelastic (necessity). When NTC raised tariffs by 20%, revenue increased because consumers couldn’t easily reduce usage.
Pathao’s Surge Pricing: During peak hours (e.g., 8–10 PM in Kathmandu), demand for rides is inelastic (urgent need). Pathao raises prices, and TR increases.

3. Determinants of Price Elasticity

Factors that influence how sensitive demand is to price changes:

Factor	Explanation	Nepalese Example
Availability of substitutes	More substitutes → higher elasticity.	Khalti vs. eSewa (cross-elasticity).
Necessity vs. luxury	Necessities (rice) are inelastic; luxuries (iPhones) are elastic.	Daraz’s electronics vs. groceries.
Proportion of income spent	Goods taking a large % of income (e.g., cars) have higher elasticity.	Motorcycle demand in rural vs. urban Nepal.
Time horizon	Longer time → more elastic (consumers find substitutes).	Fuel price hikes: short-term inelastic, long-term elastic (shift to EVs).
Brand loyalty	Strong brands (e.g., Coca-Cola) have inelastic demand.	Ncell vs. local SIM cards.

4. Income Elasticity of Demand (YED)

Measures how demand changes with consumer income.

YED Range	Interpretation	Example in Nepal
$E_{i} > 1$	Luxury goods (demand grows faster than income).	Smartphones, international travel.
$0 < E_{i} < 1$	Normal goods (demand grows with income).	Rice, clothing.
$E_{i} < 0$	Inferior goods (demand falls as income rises).	Local noodles, public transport.

Worked Example: Remittance-Driven Demand Nepal’s remittance income rose by 15% in 2023. If demand for international travel increased by 25%, calculate YED.

$E_{i} = \frac{%Δ Q _{d}}{%Δ I} = \frac{25%}{15%} = 1.67$ Interpretation: Travel is a luxury good in Nepal (YED > 1).

5. Cross-Price Elasticity of Demand (XED)

Measures how demand for one good responds to price changes in another good.

XED Range	Relationship	Example
$E_{x y} > 0$	Substitutes (price of y ↑ → demand for x ↑).	Khalti vs. eSewa, petrol vs. CNG.
$E_{x y} < 0$	Complements (price of y ↑ → demand for x ↓).	Printers and ink, cars and petrol.
$E_{x y} = 0$	Unrelated goods.	Mobile phones and toothpaste.

Worked Example: Petrol and Public Transport in Kathmandu If petrol price rises by 10% and demand for public transport buses increases by 8%, calculate XED.

$E_{x y} = \frac{8%}{10%} = 0.8$ Interpretation: Petrol and buses are substitutes (XED > 0).

6. Advertising Elasticity of Demand

Measures how demand responds to advertising expenditure.

$E_{a} = \frac{%Δ Q _{d}}{%Δ A}$

Example: Daraz’s Marketing Spend Daraz increased its ad budget by 30%, and demand for its platform rose by 45%. Calculate advertising elasticity.

$E_{a} = \frac{45%}{30%} = 1.5$ Implication: Daraz should increase advertising to boost sales (since $E_{a} > 1$ ).

7. Applications of Elasticity in Business Decisions

Decision Area	How Elasticity Helps	Nepalese Example
Pricing strategies	Avoid price hikes for elastic goods (lose revenue).	NTC’s fuel price adjustments.
Taxation policy	Tax inelastic goods (e.g., salt) to raise revenue without reducing consumption.	Nepal’s excise duty on cigarettes.
Advertising budget	Spend more on goods with high advertising elasticity (e.g., smartphones).	Xiaomi’s aggressive marketing in Nepal.
Substitute analysis	Identify competitors (high XED) and differentiate products (low XED).	Daraz vs. Amazon Nepal.
Income targeting	Market luxury goods (high YED) to high-income groups (remittance recipients).	Luxury cars in Kathmandu.

8. Elasticity of Supply

While demand elasticity focuses on consumers, supply elasticity measures how producers respond to price changes.

$E_{s} = \frac{%Δ Q _{s}}{%Δ P}$

$E_{s}$ Range	Interpretation	Example in Nepal
$E_{s} > 1$	Elastic supply (producers can easily increase output).	Agricultural products (seasonal).
$0 < E_{s} < 1$	Inelastic supply (hard to increase output quickly).	Oil refining, airport slots.
$E_{s} = 0$	Perfectly inelastic (fixed supply).	Land, historical monuments.

Worked Example: Nepal’s Rice Supply If rice price rises by 20% and supply increases by 10%, calculate $E_{s}$ .

$E_{s} = \frac{10%}{20%} = 0.5$ Implication: Rice supply is inelastic in the short run (e.g., monsoon-dependent).

9. Total Revenue (TR) and Elasticity

The relationship between PED and total revenue is critical for businesses:

PED Range	TR When Price ↑	TR When Price ↓
Elastic ( $∣ E_{d} ∣ > 1$ )	TR falls	Avoid price hikes; use discounts.
Unit elastic ( $∣ E_{d} ∣ = 1$ )	TR unchanged	Price changes neutral.
Inelastic ( $∣ E_{d} ∣ < 1$ )	TR rises	Raise prices to boost revenue.

Graphical Relationship:

graph LR
    A["Price (P) ↑"] -->|"If Elastic"| B["TR ↓"]
    A -->|"If Inelastic"| C["TR ↑"]
    D["Price (P) ↓"] -->|"If Elastic"| E["TR ↑"]
    D -->|"If Inelastic"| F["TR ↓"]

Real-World Example: Ncell’s Data Plans Ncell noticed that when it raised data prices by 15%, demand fell by 25% ( $E_{d} = 1.67$ ). Since demand was elastic, TR fell, forcing Ncell to revert to discounts.

10. Dynamic vs. Static Analysis

Feature	Static Analysis	Dynamic Analysis
Time Frame	Short-run (immediate effects).	Long-run (adjustments, substitutions).
Elasticity	Often inelastic (no time to adapt).	More elastic (firms/consumers adjust).
Example	Immediate reaction to fuel price hike.	Shift from petrol to electric vehicles.

Nepalese Example:

Static: After a 10% petrol price hike, bus fares rise immediately (inelastic demand).
Dynamic: Over 5 years, more people switch to buses or bikes (elastic response).

In the Real World

Pathao’s Surge Pricing
- Idea Used: Price elasticity of demand (dynamic analysis).
- How: During traffic jams (e.g., Thapathali to Kantipath), demand for rides is inelastic (urgent need). Pathao raises prices by up to 300%, and total revenue increases because riders still need the service.
NTC’s Electricity Tariff Adjustments
- Idea Used: Income elasticity + inelastic demand.
- How: Household electricity demand in Nepal is inelastic (necessity). When NTC raised tariffs by 20% in 2023, revenue increased because consumers couldn’t easily reduce usage. However, industrial demand (more elastic) fell slightly.
Daraz’s Discount Wars
- Idea Used: Cross-price elasticity + advertising elasticity.
- How: Daraz uses price cuts on electronics (elastic demand) to attract customers, then upsells complementary products (e.g., chargers, accessories) with inelastic demand. Their aggressive advertising (high $E_{a}$ ) also shifts demand from physical stores to their platform.

Exam Tip

Always state the formula before plugging in numbers (e.g., "Using the arc elasticity formula...").
Interpret elasticity values clearly:
- "Since $E_{d} = 0.8$ , demand is inelastic, so a price hike will increase total revenue."
Graphical questions:
- Draw demand curves with slopes (steep = inelastic, flat = elastic).
- Label equilibrium points and TR curves (TR = P × Q).
Real-world connections:
- Link PED to Nepalese examples (e.g., "Like NTC’s fuel pricing,...").
- For YED, use remittance data (e.g., "As income rises due to remittances, demand for smartphones increases by more...").
Common pitfalls:
- Sign errors: PED is always negative (inverse relationship), but we use absolute values.
- Units: Elasticity is unit-free; don’t confuse it with slope.
Short-answer tips:
- Advertising elasticity: "Measures how much demand changes with a 1% change in ad spend."
- Cross-elasticity: "Positive for substitutes (e.g., Khalti vs. eSewa), negative for complements (e.g., petrol and cars)."

Final Mermaid Summary:

mindmap
  root((Elasticity in Microeconomics))
    PED
      Formula: %ΔQ/%ΔP
      Degrees: Elastic, Inelastic, Unit Elastic
      Business Use: Pricing, TR Maximization
    YED
      Formula: %ΔQ/%ΔI
      Types: Normal, Inferior, Luxury
      Example: Remittances → Smartphone Demand
    XED
      Formula: %ΔQx/%ΔPy
      Substitutes: Positive XED
      Complements: Negative XED
    Applications
      Taxation: Tax inelastic goods
      Advertising: High Ea → More Ads
      Substitutes: Identify competitors

Based on the TU BBS syllabus for microeconomics for business, unit 3.

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